The Honorable Gray Davis

August 2, 2000

The Honorable Gray Davis

Governor

State of California

The California State Capitol

Sacramento, CA 95815

Dear Governor Davis:

In response to your letter of June 15th, included as Attachment 1, the attached report analyzes the electricity conditions facing California, including the Bay Area black-outs of June 14th and the circumstances giving rise to forced outages and related pricing problems. Your concerns have proved well-founded in light of recent retail price escalations in San Diego and the state-wide wholesale price upsurges. The Bay Area outages and the San Diego price increases are only the first manifestations of problems in our electricity system.

We applaud your leadership in calling on the Federal Energy Regulatory Commission to extend California’s authority to institute wholesale electricity price caps and to examine whether California’s energy markets are yet competitive. Prompt federal action to give California the tools to handle electricity pricing problems is crucial for California’s economy and families.

You also asked us for findings and recommendations resulting from our investigation. Both the Bay Area black-outs and the San Diego retail price spikes grow from the same roots. Thus, in the report we have described past actions and policy changes that set the stage for the energy supply and pricing issues we now face.

This report underscores the importance of collaboration and coordinated action among your agencies and appointees. We suggest that you consider forming a task force to address energy issues, comprised of the following: the President of the Public Utilities Commission, the Chair of the Electricity Oversight Board, the Chair of the Energy Commission, The Secretary of the California Environmental Protection Agency, the Secretary of the Resources Agency and the Director of the Governor’s Office of Planning and Research. An Administration task force should work together to develop effective and efficient solutions to the problems identified in this report.

We note that this investigation has been conducted on an emergency basis during the past month. This report is not an exhaustive academic, economic or policy analysis of all the issues relating to electricity. Instead, we endeavor to provide merely a context and explanation for recent events and our findings relating thereto.

We have faced many challenges and frustrations in obtaining documents and facts that would have enabled us to analyze events fully or come to comprehensive conclusions. We intend to continue our investigation until we have the facts. As we have operated under emergency conditions, we have necessarily relied upon the best information available to us within this time frame. Thus, the information to which we refer may contain inadvertent errors, as we have relied on others’ data and projections.

We look forward to working with you to find the facts and design responsible and workable solutions to California’s electricity challenges.

Michael Kahn / Loretta Lynch
Chairman / President
Electricity Oversight Board / Public Utilities Commission

Executive Summary

California is experiencing major problems with electricity supply and pricing caused by policies and procedures adopted over the past ten years. This summer, California has seen both electricity price volatility – exemplified by huge increases in wholesale electric prices and increases in retail prices in San Diego – and supply and delivery system instability – culminating in unprecedented black-outs in the Bay Area. These serious, but thus far isolated, examples represent a precursor of what lies ahead for California’s economy over the next 30 months. California’s reliability deficits and retail price volatility may not improve in that time without a mid-course correction.

I.  Sharply Higher San Diego Prices and Bay Area Black-Outs Warrant Major Concern.

Since June, wholesale prices for electrical power in California have increased on average 270% over the same period in 1999, resulting in over $1 billion in excess payments for electricity. During the week of June 14, purchasers of California power spent $1.2 billion on electricity, 300% more than they paid during the same period in l999 and 1/8th of their cost of power for all of 1999. Had the 1999 price cap of $250/MW been in place in 2000, electricity purchasers would have saved $110 million on June 14 alone. San Diegans -- the first to be exposed to unregulated electricity prices – saw their June electricity bills double. Other Californians are protected temporarily by retail rate freezes scheduled to expire no later than December 31, 2001.

Hot weather, aging power plant and transmission infrastructure, and dysfunctional bidding behavior in the wholesale power markets combined to drive prices up and to create inadequate electricity supplies in the Bay Area. Changes in power system governance resulted in PG&E being ordered to black-out over 100,000 of its customers – without an ability for the State to weigh in on that decision.

The Bay Area black-outs, the run up in prices in the wholesale electricity markets, and the rise in retail electricity prices in San Diego show that the new system is not working for California. Because of serious market defects and tight supply of electricity, purchasers of California power will likely pay billions more in electricity costs this year. Moreover, these price increases do not necessarily fund new investments in electricity supply or delivery reliability – they may flow solely to power producer profit margins.

As the following chart indicates, supply projections demonstrate California must tackle these problems in the immediate term. California cannot solve its immediate supply shortage by simply waiting or solely by building power plants that cannot come on line for several years.

5

Because of the policies and procedures adopted over the last ten years, the data we need to assess wholesale market pricing and supply scheduling behavior is in the hands of two private, autonomous entities: the California Independent System Operator and the Power Exchange. Despite the Electricity Oversight Board’s legislative mandate to oversee those institutions, we have been unable to obtain this data. Nevertheless, as detailed in Section II, we believe enough evidence of questionable behavior exists that the Attorney General should conduct an investigation into these statewide market practices, coordinating with other State agencies, including the PUC and the EOB. Such an investigation would provide the factual foundation that California policymakers and regulators need to recover any illegally obtained profits. Further, the ability of State regulators to obtain information from industry participants and to set and enforce standards is an essential element in restoring stability and predictability for California consumers.

II.  The New Structure of California’s Electricity Market Federalized Electricity Regulation and Limited California’s Ability to Protect California Business and Consumers.

The complexity of California’s problems is a reflection of the complexity of its new market structure. California embarked on an experiment to redesign the electric industry during the 1990s. Past administrations split up California’s integrated electricity system, previously dominated by state-regulated utilities, into isolated components and opened the electricity generation component to market competition. The theory behind this policy shift was that competition would lower consumer prices and encourage cleaner, non-nuclear power sources. As the Los Angeles Times succinctly stated “Cheap, reliable power was the aim in the dismantling of a decades-old system of utility monopolies that generated and delivered power and regulators that decided what customers would pay.”[1] That system caused business and consumer outcry that Californians were paying on average 50% more for electricity than other states and concerns that state policy favored nuclear and heavily polluting power plants, stifling cleaner, more efficient options.

Although laudable, the promises of that restructuring experiment have not materialized. Californians still pay substantially more on average than counterparts in other states who have not shifted to competitive market structures. Compounding the problem, decisionmakers in past administrations traded away the State of California’s ability to project, plan for and act to control electricity supply shortages and wholesale and retail price run ups. A momentous consequence of California’s attempt to create a market in electricity is that the federal government now regulates California’s electric system. Washington D.C. now controls pricing decisions directly at the wholesale level and indirectly at the retail level and, to the extent that supply incentives are correlated to prices, Washington, D.C. now affects California’s ability to attract new investment in power plants.

In designing the new system, California policymakers relied on projections of supply and demand, and pricing theories flowing from those projections, that have not come true. Past Public Utilities Commission (PUC) and legislative decisions did not, as the Orange County Register noted, take consumer interests into account.[2] By handing the reins of California’s electric system to federal regulators, the State of California no longer possesses the ability to protect California businesses and consumers.

Past administrations’ willingness to cede the State’s authority to the federal government combined with the legislative creation of two non-public supervisory organizations that have no duty to protect the public or consider the retail customer. The “Independent System Operator” (ISO) and the “Power Exchange” (PX), the nonprofit private corporations that operate the State’s transmission system and control wholesale pricing policies, are governed by boards whose members can have serious conflicts of interest. Some of these board members or their companies financially benefit from higher prices in electricity markets. Neither of these private organizations is accountable to the State or its consumers, and neither is charged with the task of keeping electricity prices reasonable for consumers and businesses.

The State of California no longer possesses the tools to ensure that its citizens can procure reliable electric service at reasonable prices. Delegating the State’s responsibility to assure reasonable electricity prices and to assure the safe delivery of power, has produced unacceptable costs. Electricity is too fundamental a necessity for California’s economy and indeed for every Californian to leave accountability for its delivery and pricing so fragmented.

III.  State Decision-Makers Must Tackle Each of Four Separate Components That Jointly Affect Electricity Reliability and Prices.

California possesses few options to turn back the clock. Any significant change in direction would cause its own disruptions. But to do nothing in hopes that the market will self-correct, perhaps years from now, could stall California’s economic expansion because business needs reliable electricity supplies and stable and reasonable electricity rates to continue to grow. Moreover, it is irresponsible to impose severe economic hardship on those consumers caught in the crossfire as California develops a workable electricity market.

Much depends on the willingness of federal regulators to cooperate. California may not be able to develop a workable electric market and to fulfill the promises made to California consumers and businesses throughout the 1990s. But, this Administration should do its best to make good on others’ promises before concluding that electricity markets cannot become competitive.

Within this overall context, we offer the following recommendations. Ideas abound about how to fix the electricity market in California. However, to address only one component of the energy equation without also addressing the others is likely to fail. To act effectively, California decision-makers must tackle four fundamental and intertwined components of the electricity problem:

·  Enhance the State of California’s Ability to Protect Consumers and Hold Market Players Accountable.

Despite the federalization and the fragmentation of the State’s electric services, the State of California should protect its businesses and consumers from cartel pricing; collusive behavior; inadequate power plant maintenance and lack of market planning for adequate electricity supplies. The State of California must try to deliver on past promises to create a workable market while shielding businesses and consumers from the current market’s flaws.

The two most important institutions controlling the sale and transmission of electricity in today’s market—the ISO and the PX—are private, autonomous entities. Their governing boards include a large number of market participants, including those likely to profit the most from high prices. But the ISO and PX are not accountable to the State of California or to the ultimate consumers of electricity. The CPUC and the EOB will continue their investigation of this summer’s events and enlist the Attorney General to determine how events transpired. Once facts have been developed, specific solutions to improper behavior can be developed.

·  Revitalize California’s Commitment to Clean, Efficient Energy Use to Improve Electric System Reliability.

Power plant construction is a capital-intensive endeavor with long lead times. Today’s policymakers should determine what constitutes adequate electricity capacity and should find ways to streamline plant siting and plant construction consistent with environmental requirements. The best way to address immediate shortfalls and to ensure clean and efficient energy generation is to invest in proven energy efficiency and renewable technologies and programs to reduce base load and peak demand.

Environmental short-cuts will not resolve California’s power needs for Summer 2000 or 2001 and even if tried will likely be precluded or delayed by federal environmental mandates and citizen suits. In the short-term, focusing on reducing base electricity demand through smart energy use and renewable energy sources holds the key to surviving Summer 2001 successfully. Moreover, transmission upgrades – especially in the Bay Area and San Diego – that can be accomplished within one year should also be made a priority. In the longer term, determining what additional supply is needed and where—and building it—should be addressed.

·  Address Wholesale Price Volatility in an Era of Electricity Shortages.

California must make federal regulators understand the effects of unmitigated wholesale prices on its economy and its citizens. The State and the ISO must speak with one voice before the FERC and request extensions of wholesale price cap authority and ask for a finding that California’s wholesale electricity markets are not competitive.

The California PX, as the primary market-maker for wholesale energy in California, should work with energy providers and consumers to make more products available to manage wholesale price risk. These options include alternatives to the single price auction in spot markets, and improved price disclosure for the products traded on its exchange. These actions are necessary to provide California with the tools to manage California’s developing wholesale electricity market.

·  Manage Retail Price Problems Until a Market Develops and is Fully Functional.